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I was just reading Thursday's great DRIP Port article about The Allure of Dividends.
(I occasionally lag behind by a few days as I usually read the FoolUK's latest stories before, though I have investments in both countries)

The mention of how dividends contributed 40% of total returns before even considering reinvested divvies, reminded me of a really superb Fool's Eye View article run on the British sister site, back in March, which I think will probably reflect the essential truth of investing in the US as our equity markets have in the long run performed rather similarly. I've included an excerpt below.

(And yes, your subscription to allows you to use the boards and My Fool features on the site if you so desire, so feel free to look around if you follow a link)

I've been writing down my thoughts on investment strategy in general, including links to great Fool articles that have influenced my philosophy, and will probably get round to posting it on the FoolUK's Investment Strategy board in due course. (I find it beneficial to type it in, to help clarify my own thinking and spur any thoughts or mathematics that I feel would be insightful)

While we're on the subject, though, I'll post an excerpt on the importance of reinvesting dividends, edited slightly, explaining the occasional United Kingdom-specific term...

Keep reinvesting those dividends!

I know that over half the annualised returns of the [London] stock market over the last 80 years have come from reinvesting dividends into the market, with the smaller part coming from the capital growth on the original investment.

[For US readers, the UK market has shown a similar average AER over the last century as the US market - around 12.5%, if I recall correctly, which probably works out nearly identical after you adjust for currency exchange rates, which have slowly changed over that time in favour of a 'stronger' dollar]

[Note: A Gilt is a UK Government bond - essentially risk-free like a Treasury-bond]

I recommend reading a superb Foolish article published in March
which quotes from the CSFB Equity-Gilt review and extracts this memorable statistic:

Over the last 80 years the average annual return from capital growth alone in UK equities has been 3.1%. But add in dividends each year and the return more than doubles to 8.2%. That is amazing. It means that more than half the total return comes from dividends. Now they suddenly seem a lot more important, don't they?

The above figures are inflation-adjusted, I believe, so if these low-inflation times (2% inflation as opposed to around 4% average over the last 80 years) continue for the next few decades, the traditional historic returns of 12% or more may come down a fair bit in future, especially as the last few decades have seen an increase in share ownership which might have contributed some of that capital growth by pushing P/E multiples upwards. I suspect, though, that "expansion of multiples" may account for only 1 or 2% per annum at most, as this would account for a twofold to fourfold increase in total 80 year return (see below).

(For what Warren Buffett in Nov 99 thought we should realistically expect in coming years (pre crash), see,1640,5656,FF.html )

Also, the figures suggest that dividends, reinvested, contribute 5.1% to the annualised return percentage, rather higher than the 3.5% assumption (an educated guess?) mentioned recently in "FTSE to hit 17,000":
an article that in other parts had used data from the CSFB Equity-Gilt study. To be honest, for my own projections, I'd much rather use the inflation-adjusted "real terms" historic growth rates mentioned in the excerpt above.

Also, I dispute the use of the word "double" when referring to a compound growth rate as it can distort the overall picture positively or negatively in the mind of the reader. It's only double for periods of around 1 year (and only then on average, after you've held the shares and the dividend has risen over time, not in any particular year, like year one). We're talking 80 years here.

[when reading the next bit, of course, the math works for US or Canadian dollars ($) or Indian Rupees just as well as it does for British pounds (£)]

Start with the annualised capital growth rate alone:
£1,000 invested at 3.1% APR for 80 years would be worth £11,500 at the end.

Now try doubling that annualised rate:
£1,000 invested at 6.2% APR for 80 years would be worth £123,000 at the end.

Now try using the actual historic rate with reinvested dividends:
£1,000 invested at 8.2% APR for 80 years would be worth £547,000 at the end.

One can see that doubling that annual rate makes an eleven-fold difference over 80 years, so a doubling in one timeframe isn't a doubling in another, it's far more than that over the long haul, so reinvesting dividends can be immensely important to your wealth.

It's also clear how fees of even 1% can eat into returns.
£1,000 invested at 7.2% APR for 80 years would be worth £260,000 at the end.

Don't forget that these amounts sound like huge and unrealistic returns because many of us are used to thinking about periods of 20 or 30 years until retirement, not 80 years...
7.2% over 30 years turns in an 8-fold increase for example (in today's money).
3.1% over 30 years turns in a 2.5-fold increase (e.g. £1000 becomes £2500 in today's money)
6.2% over 30 years turns in a 6-fold increase (e.g. £1000 -> £6078) - which is still more than double 3.1%.
8.2% over 30 years is about 10.6-fold increase (£1000 -> £10,637)

Don't forget that if you're planning to retire at 60 and live for 20 or 30 years more at least, a large portion of your savings pot can stay in the market for that extra 20 or 30 years, so periods of 60 years or more aren't unrealistic considerations for at least some of people's retirement pot. And if you don't have to "cash it in" in one go, you can smooth your returns by "pound cost averaging" as you withdraw gradually, or you could allocate much of your resources to a high-yield portfolio and largely live off the income.

[Below, an ISA is the British version of an IRA, though it's not exclusively for retirement purposes but Savings in general, hence the S, and its name doesn't have terrorist/freedom-fighter connotations!]

If you use an ISA, for example, it would be a Foolishly good idea to pay the fees from outside the ISA (e.g. by direct debit from your bank account) and have the dividends retained within the ISA. That way you're not tempted to spend the dividends and you maintain the tax relief on the highest amount possible, which could become substantial after many years of investing.

It's interesting to look at the spread of Foolish techniques to see how their gains are likely to arise:

Rule Breaker is almost entirely about capital appreciation.

Rule Maker is largely about capital appreciation, with a little help from dividends.

The UK's RuleShaker is a mixture of the two US Fool approaches mentioned above, so is mostly capital appreciation.

The Small-Cap Foolish 8 on is quite focussed on capital appreciation too.

The DRIP port on uses dividend reinvestment plans partly to reinvest the dividends and partly to minimise fees and charges for regular small investments, so dividends may make up over "half" of their APR over the full twenty years they intend to run it.

The Qualiport is likely to enjoy decent capital appreciation but the majority of the return should come from dividends if the shares are truly held for the long term.

The High Yield Portfolio is chiefly about buying and forgetting a selection of high yield companies in uncorrelated areas of business to spread risk and generate good returns on a lump sum. When used as a growth vehicle, it ought to forego major capital appreciation and obtain most of its growth through dividend reinvestment.

The PYAD Deep Value approach looks like it shares between interest on cash, which is held for long periods, fairly impressive capital gains when good shares have been available, backed up by dividends received during the wait which can be reinvested in future short-to-medium term positions. There's always the danger that if misapplied, one might "bet the farm" on a surprise bankruptcy case, so all the returns vanish! If the astounding record of capital growth continues for PYAD, interest and dividends will look paltry by comparison, but would be worthwhile in their own right for someone less skillful who averages lower capital growth.

[This approach is used by TMFPyad - an amazing investor with an astounding record who occasionally bets the farm when a value share smells unbelievably good and especially safe]

The advice to reinvest your dividends doesn't mean if you get a dividend from XYZ plc it must be reinvested in XYZ plc, but you should certainly reinvest it in the stock market in general unless you really have a short-term need for some of that money and are prepared to sacrifice some of your long-term returns.

In fact, I intend to use my dividends to purchase the great companies that sit at the most attractive valuations at the time, and I'll hold a fair amount of cash earning interest if I don't think there's anything attractive enough.

[end of excerpt]

I'm leaning towards a philosophy for my core holdings of careful pricing with a substantial margin of safety, hoping to emulate Warren Buffett, Ben Graham, etc.

If it continues to work, this might at first glance look like good timing, but as Warren Buffett has said, it's the result of good pricing and plenty of patience. This Market Comment article certainly got me thinking:

Anyway, regarding estimation of the US Market's return and the proportion from dividends, it might be possible to work this out.

If you can find a fairly representative index of shares you could work out the capital appreciation simply from the headline values of the index at start and finish.

If you can also find a Total Return Index for the same, this should equal the prospective appreciation if you reinvested the dividends. (The UK market has a rarely-quoted FTSE100-TRI Total Return Index and the oft-quoted FTSE100 (known affectionately as the "Footsie"), which is similar to the S&P500 in its collection of the top companies and the resultant range of companies and changes with stock-market fashion. I suspect the CSFB Equity-Gilt study used the FT All Share Index, representing the whole market.

If you can find, say S&P500 and S&P500-TRI values for the start and end of a long period, such as 75 years, and you can work out inflation (e.g. from a retail price index, RPI) you can work out:

CA = Capital Appreciation = S&P500(2001) / S&P500(1926)
RCA = Real-terms Capital Apprec. = CA * [RPI(1926) / RPI(2001)]
AER(RCA) = Annual Equivalent Rate = {[RCA ^ (1 / 75)] - 1} * 100%

E.G. If S&P500 was 15 times higher after 75 years after adjusting for inflation, RCA = 15.
AER(RCA) = {[15 ^ (1 / 75)] - 1} * 100%
= {[1.0368] - 1} * 100%
= 3.68%

(^ = 'raised to the power of'; * = 'multiplied by', / = 'divided by')

TR = Total Return = S&P500-TRI(2001) / S&P500-TRI(1926)
RTR = Real Total Return = TR * [RPI(1926) / RPI(2001)]
AER(RTR) = {[RTR ^ (1 / 75)] - 1} * 100%

E.G. If the S&P500-TRI were 400 times higher after 75 years after adjusting for inflation:
AER(RTR) = {[400 ^ (1 / 75)] - 1} * 100%
= {[1.0832] - 1} * 100%
= 8.32%

You can therefore say that over the period, reinvested dividends accounted for a 4.64% annual return (=8.32% - 3.68%) in real-terms, while capital appreciation alone accounted for 3.68%.

This is over half of the average annualised rate. It probably also exceeds the dividend yield in any particular year.

Obviously, these aren't the real numbers, but I wouldn't be at all surprised if the real numbers work out pretty much in the same ballpark.

Live long and prosper, Fools,

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